Question

Norris Co. has developed an improved version of its most popular product. To get this improvement to the market, will cost $48 million and will return an additional $13.5 million for 5 years in net cash flows. The firm’s debt-equity ratio is .25, the cost of equity is 13 percent, the pretax cost of debt is 9 percent, and the tax rate is 30 percent.
What is the net present value of this proposed project?

A) $989,760

B) $1,102,459

C) $1,214,318

D) $1,077,180

E) $1,306,411

Answer 1

Answer:

The NPV of the project is $1,077,180. So option D is the correct answer.

Explanation:

The cash flows from the projects are of the same amount and occur after equal intervals of time for a defined period of 5 years. Thus, they can be treated as an annuity. The net present value is the present value of future expected cash flows less the initial cost of the project. The NPV is calculated using the following formula,

NPV = Present value of annuity of Cash flows - Initial cost of the project

The amount of total assets using debt to equity is,

Total assets = Debt + Equity

And for every 1$ of equity, there is $0.25 of debt. Thus, total assets are,

Total assets = 0.25 + 1   =  1.25

The weightage of debt = 0.25 / 1.25  =  0.2 or 20%

The weightage of equity is = 1 / 1.25 = 0.8 or 80%

To calculate the present value, we will the formula for ordinary annuity cash flows as shown in the attachment. The discount rate used will be the WACC.

WACC = 0.2 * 0.09 * (1-0.3)  +  0.8 * 0.13  

WACC = 0.1166 or 11.66%

We use the after tax (1-tax) cost of debt in WACC calculation.

NPV = 13.5 * [(1 - (1+0.1166)^-5) / 0.1166)  -  48

NPV = $1.077 million or $1,077,179.716 rounded off to $1,077,180